Hendrik Bessembinder

Price Volatility, Trading Volume, and Market Depth: Evidence from Futures Markets

The relations between volume, volatility, and market depth in eight physical and financial futures markets are examined. Evidence suggests that linking volatility to total volume does not extract all information. When volume is partitioned into expected and unexpected components, the paper finds that unexpected volume shocks have a larger effect on volatility. Further, the relation is asymmetric; the impact of positive unexpected volume shocks on volatility is larger than the impact of negative shocks. Finally, consistent with theories of market depth, the study shows large open interest mitigates volatility.

Trade Execution Costs and Market Quality after Decimalization

This study assesses trade execution costs and market quality for NYSE and Nasdaq stocks before and after the 2001 change to decimal pricing. Several theoretical predictions are confirmed. Quoted bid-ask spreads declined substantially on each market, with the largest declines for heavily traded stocks. The percentage of shares receiving price improvement increased on the NYSE, but not on Nasdaq. However, those trades completed at prices within or outside the quotes were improved or disimproved by smaller amounts after decimalization, and trades completed outside the quotes saw the largest reductions in trade execution costs, as a class. Effective bid-ask spreads as a percentage of share price, arguably the most relevant measure of execution costs for smaller trades, averaged 0.33% on a volume-weighted basis after decimalization for both NYSE and Nasdaq stocks. There is no evidence of systematic intraday reversals of quote changes on either market, as would be expected if decimalization had damaged liquidity supply.

A Comparison of Trade Execution Costs for NYSE and NASDAQ-Listed Stocks

We compare average trade execution costs during 1994 for sets of large, medium, and small capitalization stocks listed on the New York and NASDAQ stock markets. All measures of execution costs examined, including quoted bid-ask spreads, effective spreads (which allow for executions within the quotes), and realized spreads (which measure price reversal after trades), are larger for NASDAQ-listed than for NYSE-listed stocks. The differentials in average trading costs across exchanges are greater for medium and small capitalization issues than for large capitalization stocks and are greater for small compared to large trades. These differentials cannot be attributed to cross-exchange differences in the adverse selection costs of market-making. Furthermore, we find no evidence that average execution costs on NASDAQ declined after the publicized events of May 1994.

The profitability of technical trading rules in the Asian stock markets

Abstract We assess whether some simple forms of technical analysis can predict stock price movement in Asian markets. We find the rules to be quite successful in the emerging markets of Malaysia, Thailand and Taiwan. The rules have less explanatory power in more developed markets such as Hong Kong and Japan. On average for our sample, mean percentage changes in stock indices on days that the rules emit buy signals exceed means on days that the rules emit sell signals by 0.095% per day, or about 26.8% on an annualized basis. We estimate “break-even” round-trip transactions costs (which would just eliminate gains from technical trading) to be 1.57% on average. We also find that technical signals emitted by U.S. markets have substantial forecast power for Asian stock returns beyond that of own-market signals. This is consistent with the reasoning that the technical rules identify periods when global equilibrium expected returns deviate substantially from their unconditional mean.

Bid-ask spreads in the interbank foreign exchange markets

Abstract This study provides evidence on quotations and bid-ask spreads in the wholesale foreign exchange market, and introduces a method to document variation in the placement of quotes relative to asset value. I find that spreads widen with proxies for inventory-carrying costs, including forecasts of price risk and a measure of liquidity costs. Increases in spreads before nontrading periods can also be attributed to inventory costs. The location of currency quotes in relation to value is not constant, and the outcome of hypothesis tests regarding changes in currency value can be sensitive to allowances for variation in quote location.

Time-varying risk premia and forecastable returns in futures markets

Abstract We document that instrumental variables known to possess forecast power in equity and bond markets (Treasury bill yields, equity dividend yields, and the ‘junk’ bond premium) also possess forecast power for prices in agricultural, metals, and currency futures markets. The pattern of forecastability in futures is consistent with economic equilibrium as embodied by a two-‘latent-variable’ model. We test whether the latent variables that explain these futures returns coincide with latent variables that explain returns on size-ranked equity portfolios. This hypothesis is rejected, suggesting that futures are subject to different sources of priced risk than are equities.

Quote-based competition and trade execution costs in NYSE-listed stocks

Abstract This study examines quotations, order routing, and trade execution costs for seven markets that compete for orders in large-capitalization NYSE-listed stocks. The competitiveness of quote updates from each market varies with measures of the profitability of attracting additional order and with volatility and inventory measures. The probability of a trade executing on each market increases when the market posts competitive quotes. Execution costs for non-NYSE trades when the local market posts competitive (non-competitive) quotes are virtually the same (substantially exceed) costs for matched NYSE trades. Collectively, these results imply a significant degree of quote-based competition for order flow and are consistent with off-NYSE liquidity providers using competitive quotations to signal when they are prepared to give better-than-normal trade executions.

Trading Activity and Transaction Costs in Structured Credit Products

After conducting the first study of secondary trading in structured credit products, the authors report that the majority of products did not trade even once during the 21-month sample. Execution costs averaged 24 bps when trades occurred and were considerably higher for products with a greater proportion of retail-size trades. The authors estimate that the introduction of public trade reporting would decrease trading costs in retail-oriented products by 5–7 bps. Structured credit products (SCPs), including asset-backed securities (ABSs) and mortgage-backed securities (MBSs), compose one of the largest (comparable in size to the US Treasury security market) but least studied segments of the financial services industry. SCPs are complex instruments that include the payment obligations of numerous borrowers, contain multiple tranches that differ in terms of payment priority in case of default, and have sizes that can change randomly as underlying loans are repaid. Uncertainty regarding SCP valuation played a role in the recent financial crisis, owing in part to the fact that secondary trades for SCPs occurred in an opaque dealer market without public quotes or trade reports. Since May 2011, FINRA has required broker/dealers to report transaction prices and quantities for SCP trades to the TRACE (Trade Reporting and Compliance Engine) system. However, FINRA does not yet disseminate data for most SCP transactions to the public. Effective 5 November 2012, the U.S. SEC approved the public dissemination of transaction prices in a subset of SCPs (specifically, in “to-be-announced” securities). FINRA has recently proposed that trade prices of SCPs, including MBSs and ABSs, be disseminated to the public. For investors as well as regulators, the key difficulty in an opaque market lies in establishing the prevailing market price. Investors cannot compare their own execution prices with those observed for other transactions. Even institutional investors have to invest significant time and effort to obtain market information, either via ‘‘indicative’’ quotes obtained through messaging systems or by telephone calls to dealers. Increased transparency has the potential to reduce dealer markups, provide information on the fair price of securities, and improve the ability to control and evaluate trade execution costs. In this study, we examined the accumulated FINRA data to provide what we believe is the first comprehensive description of this important but little-studied market. The data include all secondary market transactions for the universe of US SCPs from 16 May 2011 to 31 January 2013. We report on trading activity by subtypes of SCPs, the determinants of secondary market trading, and estimates of transaction costs in each type of SCP. Finally, focusing on segments of the corporate bond market that are comparable to segments of the SCP markets in terms of key characteristics, we present estimates of the potential effects of implementing transaction dissemination in these markets. Notably, less than 20% of the SCP universe traded at all during the 21-month sample period. One-way trade execution costs for SCPs averaged about 24 bps. However, trade execution costs varied substantially across SCP categories, from 92 bps for CBOs to just 1 bp for TBA securities. We show that trading costs depend in particular on what we term the product’s “customer profile,” which depends on issue size and the proportion of retail to institutional-size trades. Subproducts with an institutional profile tend to have lower costs. The highest average trading costs are observed for agency CMOs (74 bps) and CBOs (92 bps), each of which has a low (22% or less) proportion of large trades. The lowest average trading cost estimates are observed for TBA securities (1 bp), CMBSs (12 bps), and ABSs secured by auto loans and equipment (7 bps), each of which has a substantial (54% or greater) percentage of large trades. By matching SCP subtypes with corporate bonds that are comparable in terms of customer profile, we present rough estimates of the potential impact of introducing price transparency for the SCP markets. Our analysis indicates that price transparency is likely to be associated with substantial decreases of 5–7 bps in one-way trading costs for MBSs, agency CMOs, and CBO securities, as well as securities in the subgroups TRAN and WHLN. We anticipate smaller trading cost reductions of about 2 bps for private label CMOs. In contrast, we anticipate little or no change in trading costs for CMBSs and SBA securities, as well as ABSY issues and CDOs. Broadly speaking, this analysis indicates that trading cost reductions are most likely to be observed for SCPs with a retail clientele, whereas transaction dissemination is less likely to be relevant for those products with an institutional clientele, which already carry lower trading costs.After conducting the first study of secondary trading in structured credit products, the authors report that the majority of products did not trade even once during the 21-month sample. Execution costs averaged 24 bps when trades occurred and were considerably higher for products with a greater proportion of retail-size trades. The authors estimate that the introduction of public trade reporting would decrease trading costs in retail-oriented products by 5–7 bps.

Gains from Trade under Uncertainty: The Case of Electric Power Markets

This article refocuses attention on the potential efficiency gains from competitive wholesale power trading, which allows the diversification of demand risk. The greatest efficiency gains obtain when power demand is least correlated across markets and when there is substantial cross-sectional variation in expected demand. Real-time power trading can reduce retail prices by conservative estimates of 3%–4% on average in the United States, and forward and real-time trading can reduce prices by a combined 6%–10% or more. Economic efficiency would be best served by policy ensuring that deregulated power markets are indeed competitive, rather than by renewed regulation.

Market Making Contracts, Firm Value, and the IPO Decision

We examine the effects of secondary market liquidity on firm value and the decision to conduct an Initial Public Offering (IPO). Competitive liquidity provision can lead to market failure as the IPO either does not occur or the IPO price is discounted to reflect that some welfare-enhancing secondary trades do not occur. Market failure arises when uncertainty regarding fundamental value and asymmetric information are large in combination. In these cases, firm value and social welfare are improved by a contract where the firm engages a Designated Market Maker (DMM) to enhance liquidity. Our model implies that such contracts represent a market solution to a market imperfection, particularly for small growth firms. In contrast, proposals to encourage IPOs by use of a larger tick size are likely to be counterproductive.We model a contract by which a firm engages a Designated Market Maker (DMM) to provide more liquidity than would be supplied in a competitive market. The DMM contract increases trading volume, and enhances allocative efficiency, price discovery and firm value. The model predicts that DMM contracts will be most valuable for (i) firms characterized by substantial information asymmetries as well as greater uncertainty regarding asset value, and (ii) firms whose real investment decisions are better informed by improved price discovery, i.e. small, young, growth firms. Our analysis indicates that contracts between listed firms and DMMs, which are currently prohibited in the U.S., can represent a market solution to a market imperfection. *This paper supersedes an earlier working paper titled “Why Designate Market Makers? Affirmative Obligations and Market Quality.” The authors thank Robert Battalio, Thierry Foucault, David Hirshleifer, Michael Lemmon, Marios Panayides, Uday Rajan, Hans Stoll, and Avanidhar Subrahmanyam for useful discussions, and seminar participants at Northwestern University, University of Pittsburgh, Case Western Reserve University, Southern Methodist University, University of Texas at Austin, University of Utah, University of Auckland, University of Sydney, University of California at Irvine, Pontifica Universidade Catolica, Fundacao Getulio Vargas, and York University for comments.